Breakeven Inflation Research Articles

Decomposing the Term Structure of Interests Rates: Evidence from a Small Open Economy

This paper uses Israeli data of inflation-indexed and nominal government bonds to estimate a discrete-time essentially affine term structure model. To estimate the model, I use a uniquely long-spanned sample of monthly real yields for the period of 01/1985-03/2018. The nominal yields data spans the period of 05/2001-03/2018. I document an unconditional upward sloping real term structure that the model ascribes to a rising real term premium while the average expected real short rates are relatively flat. A decomposition of the break-even inflation shows that the unconditional term structure of the inflation premium is increasing with maturity and most of the variance in the short end is due to expected inflation. However, in the long end, most of it is due to the inflation term premium.

Oil price dynamics and market-based inflation expectations

We examine the link between oil prices and market-based inflation expectations in the United States. Using a Gaussian affine term structure model, we decompose the breakeven inflation into three components: the market-based inflation expectations, the inflation risk premium and the liquidity risk premium. We show that oil prices have a nonlinear impact on the 5- and 10-year market-based inflation expectation components. Specifically, we find that the impact of oil price changes on inflation expectations is more intense when oil prices are above a threshold of 67 USD per barrel and is more pervasive for the intermediate term than for the longer term. Furthermore, we show that oil prices have a nonlinear impact on the inflation risk premium. These results have implications for the management of inflation expectations.

Simulating historical inflation-linked bond returns

Abstract Empirical research on the benefits of investing in inflation-linked bonds usually relies on a limited number of observations due to the relatively recent introduction of these assets. We estimate models for the break-even inflation rate and use these to create hypothetical inflation-linked bond returns. We compare these with the return on actual inflation-linked bond returns on a recent sample and find that surveys of professional forecasters and moving average models perform best. We confirm these findings for a sample of 19 international inflation-linked bond markets. Using surveys of professional forecasters, we create hypothetical inflation-linked bond return series for 41 countries starting in 1987 or later depending on the availability of nominal bond markets. These simulated series can be used by asset allocation researchers, but an average correlation of 0.7 means that the simulated series are at best reasonable proxies for real data on inflation-linked bond returns. This cautionary note is also relevant to appreciate existing research using simulated inflation-linked bond returns.

Practical Applications of Information Flow and Expected Inflation: An Empirical Analysis

In Information Flow and Expected Inflation: An Empirical Analysis , published in the Winter 2017 issue of The Journal of Investing , Bradford Cornell , a professor of financial economics at the California Institute of Technology in Pasadena, California, reviewed data from January 1, 2003 through November 10, 2015 to determine what news prompts a significant move in the breakeven inflation rate (BEI). His analysis indicates that the BEI responds frequently to news stories about changes in Federal Reserve interest rate policy or news related to overall economic activity and aggregate demand. In contrast, announcements related to inflation data, money supply, or fiscal policy do not seem to consistently trigger significant shifts in the BEI.

Estimação da Inflação Implícita de Curto Prazo

A inflação implícita é a diferença entre as taxas de juros nominal e real. No mercado brasileiro, ela pode ser obtida facilmente a partir de títulos públicos prefixados e indexados à inflação. No entanto, quando tratamos da inflação implícita de curto prazo, tal tarefa apresenta duas dificuldades: a) os títulos indexados à inflação possuem defasagem de indexação; b) a sazonalidade da inflação implica em sazonalidade da taxa real. O objetivo desse trabalho é propor uma metodologia para estimação da inflação implícita de curto prazo que contorne estes dois problemas. Assumindo que o prêmio de risco da inflação é pequeno no curto prazo, avaliamos a capacidade de previsão da inflação implícita confrontando-a com expectativas baseadas em pesquisas. Os resultados mostram que a inflação implícita é competitiva em relação às previsões de analistas de mercado divulgadas no Boletim Focus. Uma vantagem da inflação implícita é o fato de ela permitir um acompanhamento mais estreito das expectativas do que as pesquisas, uma vez que ela é atualizada continuamente.

Default Risk and the Pricing of U.S. Sovereign Bonds

United States Treasury securities are traditionally viewed in academics and practice as being free of default risk. In principle, nominal outstanding Treasury debt can always be repaid by issuing fiat currency. The same does not hold true, however, for inflation-indexed debt. This leads the latter to embed lower rate of recovery in case of default. We examine the relative pricing of nominal and inflation-indexed debt in the presence of risk of default. We show empirically that the breakeven inflation between nominal Treasury securities and TIPS is significantly related to the premium paid on U.S. credit default swaps (CDS), controlling for measures of liquidity and slow-moving capital. This evidence motivates us to model the prices of nominal and inflation-protected securities in a no-arbitrage setting. Our model shows that breakeven inflation is related to perceptions of differing rates of recovery in the two markets. The estimated model provides evidence that most of the TIPS mispricing after the crisis can be attributed to the exposure to default risk.

Tips from TIPS: The Informational Content of Treasury Inflation-Protected Security Prices

Treasury Inflation-Protected Securities (TIPS) are frequently thought of as risk-free real bonds. Using no-arbitrage term structure models, we show that TIPS yields exceeded risk-free real yields by as much as 100 basis points when TIPS were first issued and up to 300 basis points during the 2007–2008 financial crisis. This spread predominantly reflects the poorer liquidity of TIPS relative to nominal Treasury securities. Other factors, including the indexation lag and the embedded deflation protection in TIPS, play a much smaller role. Ignoring this spread also significantly distorts the informational content of TIPS break-even inflation, a widely used proxy for expected inflation.

Oil Price, Bond Return, and Breakeven Inflation

Compared with stocks, bonds are more directly affected by fluctuations in oil prices through the expected inflation component in nominal bond yields. Surprisingly, prior literature finds little predictive power of oil price changes on bond excess returns. This finding is counter intuitive, especially given the strong predictive relationship between oil price changes and equity risk premium. Using oil supply, global demand, and oil-specific demand shocks, estimated from a structural VAR model of oil price changes, this paper provides new empirical evidence - the oil price changes driven by global demand shocks predict negative real bond risk premium and positive inflation risk premium. Since these two effects offset each other, we observe insignificant effect on the bond risk premium. A two-sector New Keynesian model shows theoretically that real bond yield, breakeven inflation, and nominal bond yield respond differently to oil supply and demand shocks.

REAL-TIME MONITORING OF THE US INFLATION EXPECTATION PROCESS

Real-time supervision of shifts in inflation expectations is an important issue for monetary policy makers, especially in the presence of economic uncertainty. In this paper, we elaborate tools for on-line monitoring of such shifts by extracting valuable information from noisy daily financial market data. For this purpose, first, we suggest a new risk adjustment for observable proxies of medium and long run inflation expectations assuming that the latter are well-anchored. Second, we propose an econometric methodology for sequential monitoring of level changes in the associated proxies at daily frequency. Our empirical evidence shows that the on-line surveillance of risk adjusted US forward breakeven inflation rates by means of the cumulative sum (CUSUM) detector appears to be helpful to extract timely signals on potential shifts. In particular, the obtained signals indicate important turning points in market-based measures of inflation expectations, which also tend to materialize in lower frequency experts' surveys.

TIPS and the VIX: Spillovers from Financial Panic to Breakeven Inflation in an Automated, Nonlinear Modeling Framework

AbstractThis paper examines the determinants of the breakeven inflation rate (BEI) on U.S. Treasury Inflation Protected Securities. After controlling for several measures of liquidity, inflation expectations and inflation uncertainty; financial fear itself (proxied with the Volatility Index or VIX) remains a primary influence on BEI. To delve into the mechanism underlying this association, the VIX is decomposed, using intraday data, into conditional variance and the variance premium capturing risk aversion. Aside from the 2008 crisis, most of the effect emanated from the variance premium. Following the crisis, indicators of bank insolvency risk gain prominence as well. Lastly, an automated nonlinear model finds convex effects of variance, and diminishing returns to insolvency risk and liquidity.

Volatility of commodity futures prices and market-implied inflation expectations

This study examines intricate interplay between crude oil, copper and gold futures prices, and market-implied inflation expectations that are proxied by the breakeven inflation derived from the 5-year US Treasury Note yields. We perform the Bai-Perron multiple breakpoint tests, Bayesian VAR with impulse response functions and GARCH with GED parameterization tests on daily data for the sample period January 3, 2003 – March 26, 2015. The results show a strong causal impact of shocks in the breakeven inflation on West Texas Intermediate and Brent crude oil as well as copper futures prices, albeit to varied degrees during the examined sample period. At times of low market risk and highly liquid markets West Texas Intermediate and copper futures prices move in tandem with the 5-year breakeven inflation. Prices of Brent and gold futures move in the opposite direction to the market-implied inflation.

International Real Yields

I study market-implied real yields extracted from prices of inflation-linked government bonds for nine developed countries. The liquidity premium is an important component of breakeven inflation rates. Unconditional real yield curves are upward-sloping, providing empirical support for habit models. The cross-country real rate equality is rejected. Across countries, real yields are strongly positively correlated while liquidity premia are moderately positively correlated. Low nominal yields following the Great Recession are mainly due to low real yields, although the inflation risk premia have also decreased.

Disagreement in Inflation Forecasts and Inflation Risk Premia in Brazil

The aim of this study is to investigate the link between the inflation uncertainty and the inflation risk premia implied by the term structures of nominal and real interest rates in Brazil. We gauge the latter by the difference between the breakeven inflation rate and agents’ inflation median expectations in the Focus Survey published by the Central Bank of Brazil. To proxy for inflation uncertainty, we employ the standard deviation of the 12-month inflation expectations in the Focus Survey. We first estimate the impact of inflation uncertainty on the inflation risk premia across different horizons using a VAR approach. We find that shocks in inflation uncertainty significantly affect the 9-, 12-, 24- and 36-month inflation risk premia. The impact is positive, increasing with maturity at least up to 12 months. We then estimate an alternative VAR specification that summarizes the term structure of inflarion risk premia by means of level, slope and curvature factors. It turns out that shocks in inflation uncertainty do not affect the slope and curvature factors, resulting only in parallel shifts in the inflation premium term structure. This is in line with the fact that the higher the inflation uncertainty, the higher is the compensation that investors will require to hold fixed rate bonds.

Estimating the New Keynesian Phillips Curve for the UK: evidence from the inflation-indexed bonds market

Abstract This paper utilizes the information in the inflation-indexed bonds market to estimate the New Keynesian Phillips Curve for the UK using an unobserved component approach. The main advantage of this approach comes from using the Kalman filter to explicitly estimate the unobserved expected inflation from the observed break-even inflation rates – the yield difference between the inflation-indexed bonds and the nominal bonds. Our results show that the expected inflation estimated from the unobserved component model plays a significant role in explaining the inflation dynamics in the UK. The evidence also suggests that the estimated inflation expectations are better able to capture the evolution of actual inflation process as compared to the break-even inflation rate as a proxy for expected inflation.

(The Effect of Oil Prices on Break-Even Inflation Rates of the United States)

Korean Abstract: 이 연구는 유가가 미국 물가연동국채의 손익분기인플레이션(BEI)에 미치는 영향을 실증적으로 분석하였다. 추정결과 유가의 변동이 2년·5년· 10년 BEI에 통계적으로 유의한 영향을 미치는 것으로 나타났으며, 유가 변동이 BEI에 미치는 영향력은 물가연동국채의 만기가 짧을수록 더 높았다. 이 분석결과는 기대인플레이션이 장기적으로는 통화정책의 물가안정목표에 수렴하므로 유가의 변동은 단기적으로는 기대인플레이션에 유의한 영향을 줄 수 있으나 시간이 지나면서 그 영향력이 소멸하는 속성을 갖는다는 점을 보여준다. 특기할만한 점은 시장참가자들의 중장기 기대인플레이션의 대용치인 5Y5Y BEI가 유가가 하락하고 유가 선물곡선의 기울기도 하락하는 경우에만 유가 변동에 영향을 받는다는 점이다. 이 사실은 유가와 유가 선물곡선이 동시에 하락하는 경우에만 시장참가자들이 확신을 갖고 중장기 기대인플레이션(5Y5Y BEI)을 수정한다는 것으로 해석할 수 있다. BEI가 금융시장 참가자들의 기대인플레이션이라고 간주할 경우, 이 연구를 통해 유가가 시장참가자들의 기대인플레이션에 유의한 영향을 미친다는 점을 확인할 수 있었다. 나아가 유가의 변화에 더해 미래의 유가 경로도 시장참가자들의 중장기 기대인플레이션 형성에도 기여한다고 추론할 수 있다. English Abstract: This article is an empirical study on the effect of changes in oil prices on break-even inflation rates (BEIs) of Treasury Inflation Protected Securities (TIPS) of the United States. The results of this analysis show that oil prices make a statistically significant effect on the BEIs with maturities of 2 year, 5 year, and 10 year. These sensitivities are salient in the BEIs with shorter maturities. These implies that the changes in oil prices can affect inflation expectations in the short term but this effect gets diminished to the extinction because inflation expectations depend on the inflation target of a monetary policy. Notably, the 5Y5Y BEI has a statistically significant relation with the changes in oil prices only when the slope of oil futures curve flattens and oil prices are falling. This observation reveals that financial market participants adjust their inflation expectations with confidence only in case of the simultaneous drop of the slope of oil futures curve and oil prices. Assuming the BEI is a reasonable estimator of inflation expectations extracted from financial market, oil prices make a limited impact on medium and long term inflation expectations (5Y5Y BEI). From these results we can make an inference that current movements of oil prices and financial market participants’expectation of oil price path make joint contribution to the formation of medium and long term inflation expectations.

Estimating the credibility of Brazilian monetary policy using a Kalman filter approach

The objective of this study is to estimate the credibility of the monetary policy followed by the Central Bank of Brazil (BCB) during the period 2006–2015. To estimate this credibility, we use the Kalman filter in three measures of inflation expectation: two collected via market survey and via consumer polling, as well as the breakeven inflation. The results provide evidence of the existence of three shifts in the perceived credibility of BCB inflation targets during the period analyzed: (i) credibility declined sharply in mid-2008, at the most critical moment of the subprime mortgage crisis; (ii) credibility was relatively stable from early 2009 through mid-2013; (iii) credibility trended downward thereafter, when the real interest rate was less than the minimum rate compatible with the inflation target. By associating the estimated credibility with macroeconomic and financial variables, we find a downward trend in credibility during recessionary periods and an inverse relationship between credibility and output gap, between credibility and variation in the BRL/USD exchange rate, and between credibility and historical inflation. In addition, we find that market survey and breakeven inflation credibility measures are important in predicting sovereign risk. Furthermore, changes in the inflation rate are important for predicting only credibility measured on consumer polling, validating the assumption that measures from consumer polls are backward-looking and formed based on consumers’ adaptive expectations.

Simulating Historical Inflation-Linked Bond Returns

Empirical research on the benefits of investing in inflation-linked bonds usually relies on a limited number of observations due to the relatively recent introduction of these assets. We estimate models for the break-even inflation rate and use these to create hypothetical inflation-linked bond returns. We compare these with the return on actual inflation-linked bond returns on a recent sample and find that surveys of professional forecasters and moving average models perform best. We confirm these findings for a sample of 18 international inflation-linked bond markets. Using surveys of professional forecasters, we create hypothetical inflation-linked bond return series for 37 countries starting in 1987 or later depending on the availability of nominal bond markets. These simulated series can be used by asset allocation researchers, but an average correlation of 0.7 means that the simulated series are at best reasonable proxies for real data on inflation-linked bond returns.

An empirical decomposition of the liquidity premium in breakeven inflation rates

Abstract In this paper, we propose a novel way to calculate the relative liquidity premium between the nominal and inflation-indexed government bonds. We assume that both nominal and inflation-indexed bonds contain liquidity premium. Moreover, the methodology that is used in the paper does not need survey data to extract changes in the long-run inflation expectations. Hence, we can report the changes in the long-run inflation expectations on a daily basis. We apply this methodology to the Turkish bond market data. Results of the paper indicate the existence of a relative liquidity premium that takes values between -31 basis points and 43 basis points for the period between October 2012 and November 2015. This result also shows that the inflation-indexed bonds sometimes can be more liquid than nominal bonds in Turkey.

Inflation forecasts extracted from nominal and real yield curves

Abstract The aim of this paper is to evaluate the performance of inflation forecasts backed out from the nominal and real yield curves in the United Kingdom. We use the Nelson–Siegel (NS) framework to model the break-even inflation term structure, and we base our analysis on the one-day break-even inflation derived from NS factors, which avoids the need for a direct estimation of the inflation risk premium. Fitting (vector) autoregression models augmented with nominal and/or real Cochrane-Piazzesi factors, we find that parsimonious models based on the one-day break-even inflation outperform other models in forecasting inflation out-of-sample. In addition, we quantify the parameter uncertainty and show that it may have considerable impact on inflation forecasts.

Real Time Monitoring of the US Inflation Expectation Process

The real time supervision of inflation expectations is an important issue for monetary policymakers, especially in presence of economic uncertainty. In this paper we propose a novel methodology for sequential monitoring of noisy and heteroscedastic market based daily proxies for short, medium and long run inflation expectations. Our empirical evidence suggests that the on-line surveillance of risk adjusted US forward breakeven inflation rates by means of the CUSUM detector appears to be helpful to extract timely signals on potential shifts in market expectations. In particular, the obtained signals indicate important turning points in market based measures of inflation expectations. These turning points also tend to materialize in lower frequency survey based measures.